Book value

Definition of book value reduction

What is book value reduction?

A reduction in book value decreases the value at which an asset is recorded on the books. This reduction occurs because changes in the asset or market conditions have reduced its current market value.

Key points to remember

  • A reduction in book value is the result of a decrease in the market value of an asset.
  • Reductions in the book value of an asset account are accompanied by a charge on an expense account, which reduces the net income of the income statement.
  • Many companies will publicly report both GAAP earnings, with the book value reduction charge, and non-GAAP earnings, excluding the charge.
  • When a company depreciates levels of assets unexpectedly and with little economic justification, it can signal trouble.

Understanding book value reduction

The reduction in book value is a non-cash charge recorded in the general ledger. It includes a decrease in the value of an asset on the balance sheet, as well as an offsetting charge. As such, it also reduces net profit or loss to the income statement of the same accounting period in which the reduction in book value is identified and recognised. In some circumstances, the write-down and related expense may be a large figure that could result in significant losses for the reporting entity.

Since this is an unusual item, companies generally report a net profit (or loss) according to generally accepted accounting principles (GAAP), taking into account the charge for reducing the book value, as well as “pro forma” or non-GAAP earnings that exclude the charge. A reduction in book value is more commonly referred to as an asset write-down or write-down in the popular press.

Requirements relating to the reduction of the book value

Although GAAP requires a reduction in the carrying value of an asset if there has been significant impairment, it would be impossible to test all assets for such impairment on a monthly or quarterly basis. Therefore, GAAP specifies guidelines on when such impairment tests should be performed. Specifically, property, plant and equipment and intangible assets with finite lives – which are amortized over time – should be tested for impairment when market or asset changes suggest that the carrying value of the asset may be overstated and not fully recoverable.

A possible write-down test may be appropriate in a number of situations. These include a substantial decline in the market price, an adverse change in the physical condition of the asset, economic conditions, a negative political change in the country where the asset is located, etc

Under GAAP, long-lived intangible assets that are not amortized, such as goodwill, must be tested for impairment at least annually.

Differences between GAAP and IFRS

The accounting rules regarding the reversal of book value reductions differ between GAAP and International Financial Reporting Standards (IFRS). For example, US GAAP prohibits the reversal of prior inventory write-downs, but IFRS allows it in certain circumstances. On the other hand, GAAP and IFRS prohibit reversals of goodwill impairment.

Example of book value reduction

A reduction in the carrying amount is recorded in a newspaper entry as a decrease in value in an asset account, a credit, and an increase in an expense account, a debit. For example, suppose ABC Company, a video streaming service, acquired XYZ Corp, a chain of physical movie stores, 10 years ago. ABC recorded $10 million of goodwill at the time of acquisition. Each year, under GAAP, he is required to reassess the value of his reported goodwill to determine if it is still accurate or if goodwill impairment has been incurred.

ABC Company conducts its annual goodwill test and determines that demand for physical video rentals and purchases has declined significantly since the acquisition of XYZ Corp. They also determine that the likelihood of a rebound in this market is unlikely in the future. As goodwill is depreciated, a reduction in the book value is necessary. ABC’s accountants will record a journal entry to credit the goodwill asset account and debit a goodwill impairment account. The expense will reduce ABC’s reported net income in its next income statement.

Special Considerations

Financial analysts closely monitor changes in book value estimates. When a company depreciates levels of assets unexpectedly and with little economic justification, it can signal trouble. Public companies will endeavor to explain the adjustments through their corporate communications and investor relations teams.